Foreign Direct
Investment
Dr. Ananda Hussein
Introduction
Foreign direct investment (FDI) occurs when a firm invests
directly in new facilities to produce and/or market in a foreign
country
Once a firm undertakes FDI it becomes a multinational
enterprise
FDI can be:
greenfield investments - the establishment of a wholly new
operation in a foreign country
acquisitions or mergers with existing firms in the foreign
country
Foreign Direct Investment
In The World Economy
The flow of FDI refers to the amount of FDI
undertaken over a given time period
The stock of FDI refers to the total accumulated value
of foreign-owned assets at a given time
Outflows of FDI are the flows of FDI out of a country
Inflows of FDI are the flows of FDI into a country
Trends In FDI
There has been a marked increase in both the flow and
stock of FDI in the world economy over the last 30 years
FDI has grown more rapidly than world trade and world
output because:
firms still fear the threat of protectionism
the general shift toward democratic political institutions
and free market economies has encouraged FDI
the globalization of the world economy is having a
positive impact on the volume of FDI as firms undertake
FDI to ensure they have a significant presence in many
regions of the world
The Direction Of FDI
Most FDI has historically been directed at the developed
nations of the world, with the United States being a favorite
target
FDI inflows have remained high during the early 2000s for
the United States, and also for the European Union
South, East, and Southeast Asia, and particularly China,
are now seeing an increase of FDI inflows
Latin America is also emerging as an important region for
FDI
The Direction Of FDI
Gross fixed capital formation summarizes the total
amount of capital invested in factories, stores, office
buildings, and the like
All else being equal, the greater the capital
investment in an economy, the more favorable its
future prospects are likely to be
So, FDI can be seen as an important source of capital
investment and a determinant of the future growth
rate of an economy
The Source Of FDI
Since World War II, the U.S. has been the largest
source country for FDI
The United Kingdom, the Netherlands, France,
Germany, and Japan are other important source
countries
The Form Of FDI:
Acquisitions
Versus Greenfield
Investments
Most cross-border investment is in the form of mergers and
acquisitions rather than greenfield investments
Firms prefer to acquire existing assets because:
mergers and acquisitions are quicker to execute than greenfield
investments
it is easier and perhaps less risky for a firm to acquire desired
assets than build them from the ground up
firms believe that they can increase the efficiency of an acquired
unit by transferring capital, technology, or management skills
The Shift To Services
FDI is shifting away from extractive industries and
manufacturing, and towards services
The shift to services is being driven by:
 the general move in many developed countries toward services
the fact that many services need to be produced where they are
consumed
a liberalization of policies governing FDI in services
the rise of Internet-based global telecommunications networks
Theories Of Foreign Direct
Investment
Why do firms invest rather than use exporting or
licensing to enter foreign markets?
Why do firms from the same industry undertake FDI
at the same time?
How can the pattern of foreign direct investment
flows be explained?
Why Foreign Direct
Investment?
Why do firms choose FDI instead of:
exporting - producing goods at home and then
shipping them to the receiving country for sale
or
licensing - granting a foreign entity the right to
produce and sell the firm’s product in return for a
royalty fee on every unit that the foreign entity sells
Why Foreign Direct
Investment?
An export strategy can be constrained by
transportation costs and trade barriers
Foreign direct investment may be undertaken as a
response to actual or threatened trade barriers such as
import tariffs or quotas
Why Foreign Direct
Investment?
Internalization theory (also known as market imperfections
theory) suggests that licensing has three major drawbacks:
licensing may result in a firm’s giving away valuable
technological know-how to a potential foreign competitor
licensing does not give a firm the tight control over
manufacturing, marketing, and strategy in a foreign
country that may be required to maximize its profitability
a problem arises with licensing when the firm’s
competitive advantage is based not so much on its products
as on the management, marketing, and manufacturing
capabilities that produce those products
The Pattern Of Foreign
Direct Investment
Firms in the same industry often undertake foreign direct
investment around the same time and tend to direct their
investment activities towards certain locations
Knickerbocker looked at the relationship between FDI and
rivalry in oligopolistic industries (industries composed of a
limited number of large firms) and suggested that FDI
flows are a reflection of strategic rivalry between firms in
the global marketplace
The theory can be extended to embrace the concept of
multipoint competition (when two or more enterprises
encounter each other in different regional markets, national
markets, or industries)
The Pattern Of Foreign
Direct Investment
Vernon argued that firms undertake FDI at particular
stages in the life cycle of a product they have pioneered
Firms invest in other advanced countries when local
demand in those countries grows large enough to support
local production, and then shift production to low-cost
developing countries when product standardization and
market saturation give rise to price competition and cost
pressures
Vernon fails to explain why it is profitable for firms to
undertake FDI rather than continuing to export from home
base, or licensing a foreign firm
The Pattern Of Foreign
Direct Investment
According to the eclectic paradigm, in addition to the
various factors discussed earlier, it is important to
consider:
location-specific advantages - that arise from using
resource endowments or assets that are tied to a
particular location and that a firm finds valuable to
combine with its own unique assets
and
externalities - knowledge spillovers that occur when
companies in the same industry locate in the same area
Political Ideology And
Foreign Direct Investment
Ideology toward FDI ranges from a radical stance
that is hostile to all FDI to the non-interventionist
principle of free market economies
Between these two extremes is an approach that
might be called pragmatic nationalism
The Radical View
The radical view traces its roots to Marxist political
and economic theory
It argues that the MNE is an instrument of imperialist
domination and a tool for exploiting host countries to
the exclusive benefit of their capitalist-imperialist
home countries
The Free Market View
According to the free market view, international
production should be distributed among countries
according to the theory of comparative advantage
The free market view has been embraced by a
number of advanced and developing nations,
including the United States, Britain, Chile, and Hong
Kong
Pragmatic Nationalism
Pragmatic nationalism suggests that FDI has both
benefits, such as inflows of capital, technology, skills
and jobs, and costs, such as repatriation of profits to
the home country and a negative balance of payments
effect
According to this view, FDI should be allowed only if
the benefits outweigh the costs
Shifting Ideology
Recently, there has been a strong shift toward the free
market stance creating:
a surge in FDI worldwide
an increase in the volume of FDI in countries with
newly liberalized regimes
Benefits And Costs Of FDI
Government policy is often shaped by a
consideration of the costs and benefits of FDI
Host-Country Benefits
There are four main benefits of inward FDI for a host
country:
1. resource transfer effects - FDI can make a positive
contribution to a host economy by supplying capital,
technology, and management resources that would
otherwise not be available
2. employment effects - FDI can bring jobs to a host
country that would otherwise not be created there
Host-Country Benefits
3. balance of payments effects - a country’s balanceof-payments account is a record of a country’s
payments to and receipts from other countries.
The current account is a record of a country’s export
and import of goods and services
Governments typically prefer to see a current account
surplus than a deficit
FDI can help a country to achieve a current account
surplus if the FDI is a substitute for imports of goods
and services, and if the MNE uses a foreign subsidiary
to export goods and services to other countries
Host-Country Benefits
4. effects on competition and economic growth - FDI in
the form of greenfield investment increases the level of
competition in a market, driving down prices and
improving the welfare of consumers
Increased competition can lead to increased
productivity growth, product and process innovation,
and greater economic growth
Host-Country Costs
Inward FDI has three main costs:
1. the possible adverse effects of FDI on competition
within the host nation
subsidiaries of foreign MNEs may have greater
economic power than indigenous competitors because
they may be part of a larger international organization
Host-Country Costs
2. adverse effects on the balance of payments
with the initial capital inflows that come with FDI
must be the subsequent outflow of capital as the
foreign subsidiary repatriates earnings to its parent
country
when a foreign subsidiary imports a substantial
number of its inputs from abroad, there is a debit on
the current account of the host country’s balance of
payments
Host-Country Costs
3. the perceived loss of national sovereignty and
autonomy
key decisions that can affect the host country’s
economy will be made by a foreign parent that has no
real commitment to the host country, and over which
the host country’s government has no real control
Home-Country Benefits
The benefits of FDI for the home country include:
the effect on the capital account of the home
country’s balance of payments from the inward flow
of foreign earnings
the employment effects that arise from outward FDI
the gains from learning valuable skills from foreign
markets that can subsequently be transferred back to
the home country
Home-Country Costs
The home country’s balance of payments can suffer:
from the initial capital outflow required to finance
the FDI
if the purpose of the FDI is to serve the home market
from a low cost labor location
if the FDI is a substitute for direct exports
Employment may also be negatively affected if the
FDI is a substitute for domestic production
International Trade Theory
And FDI
International trade theory suggests that home
country concerns about the negative economic effects
of offshore production (FDI undertaken to serve the
home market) may not be valid
Government Policy
Instruments
And FDI
Home countries and host countries use various
policies to regulate FDI
Home-Country Policies
Governments can encourage and restrict FDI:
To encourage outward FDI, many nations now have
government-backed insurance programs to cover
major types of foreign investment risk
To restrict outward FDI, most countries, including
the United States, limit capital outflows, manipulate
tax rules, or outright prohibit FDI
Host-Country Policies
Governments can encourage or restrict inward FDI
To encourage inward FDI, governments offer
incentives to foreign firms to invest in their countries
Incentives are motivated by a desire to gain from the
resource-transfer and employment effects of FDI, and
to capture FDI away from other potential host
countries
To restrict inward FDI, governments use ownership
restraints and performance requirements
International Institutions
And
The Liberalization Of FDI
Until the 1990s, there was no consistent involvement
by multinational institutions in the governing of FDI
Today, the World Trade Organization is changing
this by trying to establish a universal set of rules
designed to promote the liberalization of FDI
Implications For Managers
What are the implications of foreign direct
investment for managers?
Managers need to consider what trade theory
implies, and the link between government policy and
FDI
The Theory Of FDI
The direction of FDI can be explained through the
location-specific advantages argument associated with
John Dunning
However, it does not explain why FDI is preferable to
exporting or licensing
Government Policy
A host government’s attitude toward FDI is an
important variable in decisions about where to locate
foreign production facilities and where to make a
foreign direct investment